CFDP 1727

This paper uses a multicountry macroeconometric model to analyze possible macroeconomic consequences of large future U.S. federal government deﬁcits. The analysis has the advantage of accounting for the endogeneity of the deﬁcit. In the baseline run, which assumes no large tax increases or spending cuts and no bad dollar and stock market shocks, the debt/GDP ratio rises substantially through 2020. The estimates from this run are in line with other estimates. Various experiments oﬀ the baseline run are then done. If the dollar depreciates, inflation increases but the eﬀect on the debt/GDP ratio is modest. It does not appear that the United States can inflate its way out of its debt problem. If U.S. stock prices fall, this makes matters worse since output is lower because of a negative wealth eﬀect. Personal tax increases or transfer payment decreases of three percent of nominal GDP solve the debt problem, at a cost of a real output loss of about 1.6 percent over the next decade. The Fed’s ability to oﬀset these losses is modest according to the model. Introducing a national sales tax is more contractionary than is increasing personal income taxes or decreasing transfer payments.

Keywords:

Federal deﬁcit, Federal debt

JEL Classification Codes: E17

Note:

Published in Jeﬀrey Brown, ed., Tax Policy and the Economy, Vol. 25, University of Chicago Press, 2010, Ch. 4